The Wrong Trade War

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Illustration by Alex Fine

Li Xiangfu grew up in a one-room shack, lit only by a single bulb that dangled from the ceiling, in a desperately poor part of Henan province, about 500 miles from Beijing. His father, after losing his leg in an industrial accident, was unable to work. His mother toiled every day in the wheat fields.

When I first met Li, in the summer of 2001 on a long train ride through central China, his life was about to change profoundly. He was on his way home from Beijing's Tsinghua University—China's version of MIT—after graduating with honors. He was about to start his first job after college, as a software engineer for a company then little-known in the West: Huawei. Founded in 1987 as a manufacturer of phone switches, Huawei was one of hundreds of suppliers to what was then the country's sleepy, state-owned telecommunications industry.

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People walk by a Huawei store on November 24, 2018 in Shenyang, Liaoning Province of China. VCG/Getty

Li has thrived in the nearly two decades since; he is now a ­senior vice president, directing a team of software developers in the emerging field of artificial intelligence, or AI. So has Huawei. The Shenzhen-based company has emerged as a leading player in the transformation of China from a low-wage manufacturing country to an industrial and technological power. It now sells more smartphones than Apple. It provides equipment that under­girds the internet and other telecommunications systems in ­China and throughout the developing world. And it's a leading player in the rollout of 5G telecom networks that will connect everyday appliances, tools and objects into an "internet of things."

Last August, Huawei became the first global technology company to release a so-called AI chipset—a range of computer chips that enable smartphones to use techniques of artificial intelligence for recognizing faces and other objects in digital images and interpreting natural language at very high speeds. The announcement demonstrates the stunning pace with which China has transformed itself from an impoverished economic backwater to a technological superpower. It's also the latest sign of China's growing ambition to exert its influence in this technology, which seems poised to transform our daily lives life and reshape global commerce.

China's ambitions have begun to cause some consternation in Washington, D.C., and Silicon Valley. In 2018, Beijing announced its Made in China 2025 plan to become a dominant player in aerospace, robotics, computer chips, biotechnology and other high-tech industries. It's the latest in China's increasingly aggressive approach to bolstering its domestic high-tech industries. As a price of doing business in China, Beijing is imposing onerous requirements on foreign companies to give up intellectual property, manufacturing know-how and control over their investments. It initiates cyberattacks on Western companies aimed at stealing trade secrets. And, in the case of Huawei, the government hides its close relationship with Chinese businesses through murky ownership structures, critics say.

For years, Washington had been content to downplay Beijing's alleged abuses because U.S. firms wanted access to its vast and quickly growing market. As long as Beijing continued to reform itself economically, the relationship was seen as a win-win. That logic no longer seems to apply. For one thing, China's economy is no longer growing at the breakneck speed of the past. And President Xi Jinping has slowed the opening of China's markets and in some areas reversed it. According to a report by the Council of Foreign Relations, the Made in China 2025 plan represents an "existential threat to U.S. technological leadership."

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US President Donald Trump (5th L) and Chinese President Xi Jinping (5th R) hold an expanded bilateral meeting at the Mar-a-Lago estate in West Palm Beach, Florida on April 7, 2017. JIM WATSON/AFP/Getty

An existential threat might be reason enough for the U.S. to get tough with China. Indeed, a full-scale trade war is now underway between the two nations. President Donald Trump has slapped 10 percent tariffs on $200 billion worth of Chinese-made steel, aluminum and a wide range of other goods. If the current round of negotiations with Beijing, which began January 7, fails to produce a deal on trade, Trump says he will increase those tariffs to 25 percent in March.

In response, China increased its own levies on a wide range of U.S. imports and cut back on purchases of soybeans and other agricultural products. At the same time, high-profile companies that produce goods in China for sale there, such as Apple Inc., are now suffering as customers shun U.S. brands (see Page 32).

The trouble is, Trump is fighting the wrong war. His tariffs ­ignore the growth industries that will have a far more significant effect on the future prosperity of advanced nations. By punishing China for steel exports, he's letting Beijing off the hook for egregious behavior toward American high-tech that could prove extremely damaging in the long term.

As the March tariff deadline looms, the Trump admin­istration has a chance to confront China's anti-market industrial policies aiming to dominate technology at the expense of other nations. Doing so would dial down the risk of a ruinous trade war and, some Beijing economic reformers say, could lead to meaningful domestic reforms. These developments would be in everyone's interest, including China's.

But the White House has yet to fashion anything close to a coherent strategy to address Made in ­China 2025. "The next wave of technological disruption and technological promise, led by AI and 5G, is upon us," says Lee Kai-fu, the former president of Google in China, who now runs his own venture capital firm (see Page 24). "As far as I can tell, no one in the U.S. government has much of a clue about how to help shape these powerful forces."

The Rise of Techno-Nationalism

China joined the World Trade Organization in 2001, the same year I met Li on the train. It was a historic landmark that symbolized the country's return to the global economy. The rest of the world, led by the U.S., had worked hard to make accession happen, believing that welcoming a country as vast and with the potential of China into a rules-based trading regime would be good for all. From that year on, China's extraordinary economic rise accelerated at a rate few foresaw. It is now the world's second-largest economy and on track to surpass the U.S. as No. 1 in a decade or two. Upon joining the WTO, China started opening its economy to investment and trade, and it promised to continue.

Under Xi, those promises were stillborn. Things got worse in key areas of the economy, including telecommunications, computing and aerospace, where Beijing promoted domestic companies. Foreign applications for patents in what China believes are "strategic ­industries," such as oil and gas, alternative energy and pharmaceuticals, are now denied at a markedly higher rate than are patent applications in nonstrategic sectors, says Marc Cohen, director of the Berkeley Center for Law and Technology, and the divergence is accelerating. When the American Chamber of Commerce in ­China surveyed business conditions in that country in 2017, 60 percent of its member companies, citing extensive and accelerating protectionism, said they have little or no confidence that China will further open its markets in the next few years.

Since China joined the WTO, U.S. multinationals hoped Beijing's demands for the transfer of technology to local joint-­venture partners—standard operating procedure in the early years after the economic opening—would diminish as Beijing's economy matured. If anything, the opposite has happened: China started demanding that foreign firms transfer ever more critical technologies to local Chinese partners—something about which the Trump administration, to be fair, has complained bitterly to Beijing.

Made in China 2025, announced at a moment of mounting frustration for U.S. and other foreign companies, imposes burdensome requirements. Foreign multinationals must move manufacturing and assembly facilities to China and collaborate with their future competitors, often as a ­minority joint-venture partner. "Implicit" in the document, says former U.S. Trade Representative Michael Froman, "was that they intend to achieve global dominance in these sectors and will do so, if need be, with significant state involvement, from outright subsidies to emerging industries to protection of Chinese 'national champions' from foreign rivals."

At the same time, as a report by Katherine Koleski, a policy analyst at the U.S.-China Economic and Security Review Commission in Washington, put it, "China has been leveraging the openness of the United States and other market-based economies to gain access to advanced research and data, acquire and invest in leading-edge firms through Chinese state financing, and freely sell their products and services abroad. The scale and volume of government resources directed toward these [efforts] severely limits the ability of foreign firms to compete fairly in China's market."

Trade experts call China's policy "techno-nationalism." The government is now more directly involved in moving resources—"massive state funding," Koleski calls it—to favored economic sectors. In AI alone, the central government says it will spend $2 billion on a technology park devoted to research and development in Beijing. Several provinces have followed suit, with parks of their own in Chengdu, Guangzhou and elsewhere. As Lee Kai-fu notes, Beijing is "turbocharging through a flood of new funding, including subsidies for AI startups and generous government contracts to accelerate AI adoption throughout the economy."

At the center of Beijing's desire to dominate key technologies is the computer chip—the primary component of the modern economy. At present, U.S. firms, such as Intel, Qualcomm, AMD and Nvidia, lead the global chip industry. China consumes 50 percent of the world's semiconductors, but 80 percent of those purchases come from foreign suppliers. That's why, of the 991 mergers and acquisitions in the global chip sector from 2014 to 2016, one-third involved China; over the next decade, according to state-owned media, Beijing intends to spend $160 billion on its indigenous industry.

AI is the key to leapfrogging the West in chips. Beijing wants other Chinese firms to replicate Huawei's success in developing revolutionary chip designs that power deep neural networks—a branch of machine learning that is key to many AI applications. They're used in driverless cars and computers that can parse the written and spoken word and recognize faces and other objects in digital images. Indeed, Made in China 2025 calls specifically for developing neural-network chips that are 20 times better than Nvidia's M40 chips, a current staple in AI applications. In July, Chinese internet search giant Baidu announced that it was developing its own machine-learning chips, and Huawei is working with Chinese firm Cambricon on AI chips for phones.

Huawei's competitors and critics believe the company's rapid development has been the result of intellectual property theft, in explicit violation of WTO rules. Cisco sued Huawei back in 2003—a suit that was eventually settled—and Canada's Nortel Networks believes China hacked its systems and stole key technology that ended up benefiting Huawei. At least one former Nortel Networks executive believes that led to the company's eventual bankruptcy. Huawei denies these allegations and cites a lack of publicly available evidence to substantiate them.

The U.S. intelligence community is deeply wary of Huawei; it suspects that Huawei's computer chips contain hidden "backdoors" that allow Beijing to hack networks built with Huawei equipment. As a result, Washington has blocked the company from investing in the U.S. The suspicions that have long followed Huawei now infect wide swathes of the U.S.-Chinese trading relationship.

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Visitors look at Huawei devices during the Mobile World Congress 2017 on the opening day of the event at the Fira Gran Via Complex on February 27, 2017 in Barcelona, Spain. The annual Mobile World Congress hosts some of the world's largest communications companies, with many unveiling their latest phones and wearables gadgets. David Ramos/Getty

Yet whether China and its key firms may have cheated to help get where they are today is irrelevant, some tech executives now say, when it comes to what's next. Lee Kai-fu argues flatly that the climate for entrepreneurship in artificial intelligence is more favorable in China than in Silicon Valley. Yes, the pioneers of deep learning are still mainly in the West, but, in his new book, AI Superpowers, Lee argues that Chinese engineers are further ahead in working to make these advances into commercial realities. That's similar to the early days of electricity in the United States, when "thousands of engineers began tinkering, using it to power new devices and reorganize industrial processes," Lee says. At the moment, China simply has more AI "tinkerers" than anyone else.

That's partly a result of an influx of venture capital. Rather than relying on government bureaucrats to pick winners, Beijing is instead making funds available to venture capitalists and other investors. In 2017, Chinese firms raised $5 billion in venture capital funding, more than U.S. firms, according to ABI Research. To be sure, that is also partly a function of China's size, which is an advantage going forward. "The key is the combination of the scale and the speed at which things are happening," says venture capitalist Gary Rieschel, founder and managing partner at Qiming Venture Partners, a Seattle-based firm. "No other country can match it."

If these fears about China sound familiar, that's because a similar hysteria gripped Washington in the late '80s and early '90s over the rise of Japan as a technological superpower. Indeed, not everyone is convinced that China will make good on its plans to dominate AI. China's universities, outside of a handful of elite institutions, are second-rate at best compared with those in other developed nations. The country has relied on Chinese ­nationals, educated abroad, to fill critical knowledge gaps at ­domestic companies. China's goals may stretch the nation's elite researchers, computer scientists and programmers.

"Just because Xi Jinping wishes for something to be so doesn't mean it will be," says Derek Scissors, an economist at the American Enterprise Institute in Washington who specializes in Chinese economic policy. Still, even the possibility of China's ambitions being realized demands a coherent policy from the U.S.

A Distracted U.S.

From what we've seen so far, the Trump administration is incapable of crafting effective policies to deal with the technology threat. Instead, it has been implementing an "agenda that concentrates on preserving heavy industry—steel and aluminum—through tariffs and currency complaints," says Jim McGregor, a former head of the American Chamber of Commerce in China and now a Shanghai-based consultant at APCO Worldwide. "These are policies better suited to the 1950s."

The driver of these White House policies is Trump himself. For decades, he has been a protectionist who believes in the power of tariffs to bring trading partners to heel. He won states in the industrial Midwest by promising to protect workers in metal-bending industries. Tariffs against China are another campaign promise kept—whether or not they constitute smart policy. His goal, Commerce Secretary Wilbur Ross has said, "is to increase the pain on China to the point where they'll find it less painful to trade fairly."

Although two of Trump's trade advisers—Peter Navarro and Ross—are outright protectionists, National Economic Council Director Larry Kudlow and Treasury Secretary Steve Mnuchin (who comes from Goldman Sachs royalty) are bona fide free traders. The media often depict U.S. Trade Representative Robert Lighthizer (see Page 30)—now the lead negotiator with Beijing—as a protectionist ally of Navarro and Ross. But he was one of the earliest voices warning about aspects of China's trade policies, including intellectual property theft and forced technology transfer; this was back when he was an attorney at Skadden, Arps, Slate, Meagher & Flom. These three agree that China has been engaging in predatory techno-nationalism and believe the U.S. must design policies to counter it.

How exactly should the administration fight the techno-war, beyond the blunt instrument of tariffs? The first step, say many current and former diplomats, should be an intense effort to rally allies to the cause; to the extent that China violates international norms in pursuit of technological dominance, it doesn't just hurt the U.S. If Washington can effectively paint Beijing as an outlier when it comes to international trade rules, it can isolate China, forcing it to confront a central question: Is it, or is it not, a responsible stakeholder when it comes to the international trading system?

The administration has shown signs of progress on this front. Last year, Lighthizer wrapped up negotiations on NAFTA with Canada and Mexico in part so he could, as one White House economic official put it, "clear the decks on the other trade issues and concentrate on the main event: China."

Then, in late December, the U.S. Justice Department brought charges against two individuals, Zhu Hua and Zhang Shilong, associated with China's Ministry of State Security, charging them with cybertheft of intellectual property across a range of industries. The two individuals were part of a larger state-directed hacking group called APT10, according to the indictment. Since not only U.S. companies were targeted, U.S. intelligence agencies shared information on the case with a wide group of allies.

When the indictments came down, Germany, Japan, the U.K. and others all issued strong statements of support and condemned the alleged Chinese practices in the process—exactly the sort of one-for-all, all-for-one diplomacy most experts believe is necessary to combat China on trade. As Adam Segal, senior fellow at the Council on Foreign Relations, wrote, "The synchronized statements show that the Trump administration has tapped into deep international frustration with China's behavior."

The second step in a tough, effective policy, many analysts argue, would be to bring economic sanctions from both the U.S. and its allies against those Chinese companies that benefited from the intellectual property theft—including, in particular, state-owned companies. U.S. intelligence agencies have shared with allies a long dossier on the identities of the Chinese beneficiaries.

No sanctions were forthcoming. According to administration sources, Mnuchin successfully argued that to bring sanctions before the resumption of the trade talks in early January would scuttle their chances of success. For the moment, the administration would simply "name and shame" the Chinese officials involved in the alleged cybertheft.

What Do We Want From China?

The episode raised a critical question for the Trump administration: Regarding trade, what does it want from China? The administration needs to be clear, to itself and to Beijing, what it is trying to achieve. To date, it has not come close to doing so. Does Trump, as some suspect, simply want a big reduction in the bilateral trade surplus, which now stands at $375 billion? Does he also want China to take more significant measures to open its markets? Does he—as Navarro has suggested—want to disrupt global supply chains in the hope of bringing back manufacturing jobs to the U.S.? Does he seek to deter China from implementing its 2025 plan? Or is it all of the above?

Beijing wants to know too. Since their re-opening to the world in the 1970s, the Chinese have been fairly pragmatic negotiators. Prior to Trump's meeting with Xi in 2017 at Mar-a-Lago, a Chinese trade official told one of his American colleagues, "We want to be able to give the President [Trump] some tweetable deliverables." The trade official never got an answer.

If, as some administration officials now whisper, the goal is to counter China's by-any-means-necessary desire to dominate the high-tech industries of the future, getting the U.S. business community on board for a frontal assault on China's industrial policies is also critical. Key aspects of Beijing's policy—most notably forced technology transfer—are expressly forbidden in the accession document Beijing signed in 2001 to join the WTO. But to date, China has been able to violate its obligation with seeming impunity because U.S. companies are reluctant to provide detailed evidence of WTO violations to the U.S. government for fear that Beijing will retaliate. The huge and growing Chinese market has been too valuable to too many multinationals for much evidence to emerge.

How could the U.S. persuade China to change its practices, without invoking retaliation? Several sources interviewed for this story answer with one of Trump's favorite words: reciprocity. "Our negotiations should be judged by enforceable reciprocity," says McGregor, "by which I mean China will be judged by its real actions, not its promises. For market access and cross-border investment, what is not allowed in one country will not be allowed in the other."

To this end, Washington has intensified scrutiny of China's direct investment in the U.S., particularly in technology. That has led to a sharp drop in the amount of money coming in from Beijing. Trump, says Michael Froman, needs to prod allies to do the same—and to keep up the pressure until there is clear evidence that Beijing is reducing its own restrictions on foreign investment and access to its market.

Focusing on industries in which state-owned companies serve as piggy banks for the ruling Communist Party—and benefit from China's illicit policies—would get Beijing's attention. That's why trade hawks were so disappointed with the lack of sanctions after the December indictments. It wasn't the first time it happened. Scissors says the Chinese "freaked out" last year when the administration targeted ZTE, a state-owned telecommunications firm, for alleged sanctions-busting in its trade with North Korea. When U.S. suppliers to ZTE complained, the U.S. backed off its sanctions threat.

That's the kind of incoherence that plagues U.S. policy as the administration again engages China in talks aimed at resolving the trade dispute—before the higher U.S. tariffs go into effect in March. But the U.S. still has some leverage: Recently, a lot of political gossip has been coming out of China that elites in the Communist Party are not happy with the current state of affairs, including the trade conflict, which appears to be slowing and weakening the Chinese economy. These rumors suggest that Xi might move sooner rather than later to try to defuse the trade issue. Already, China has said it is willing to amend Made in China 2025, has drafted new rules governing foreign investment and has reduced tariffs on foreign auto imports.

If confronted simply by the threat of even stiffer across-the-board tariffs, Xi would lose face by backing down. But if the Trump administration were smart, it would seize the moment and present some proposals meant to counter anti-market industrial policies aimed at creating dominant technology players at the expense of global competitors.

The moment is fraught, though. In early December, Huawei's chief financial officer, Meng Wanzhou, the daughter of company founder and Chairman Ren Zhengfei, was arrested in Canada at the behest of the United States, which seeks her extradition. The Justice Department suspects Meng helped direct a scheme to ship sanctioned high-tech products to Iran via Hong Kong. The arrest only added to the deeply toxic atmosphere between Washington and Beijing. Huawei and the questions that swirl around it—its rise, its tactics, its ambitions—are very much at the center of that deteriorating relationship.

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Huawei CEO Richard Yu gives a press conference to present the new Huawei Balong 5G01, a 3GPP 5G commercial chipset on February 25, 2018 in Barcelona, on the eve of the inauguration of the Mobile World Congress (MWC). The Mobile World Congress, the world's biggest mobile fair, is held in Barcelona from February 26 to March 1. JOSEP LAGO/AFP/Getty

I tried, in reporting this story, to get back in touch with Li Xiangfu, to see what he thought of all that had happened and was happening now. When I first met him, his story spoke to the hope and optimism of the new China. He was a decent, smart kid doing all the right things. He got a good job with a promising company in a booming economy. He was going to buy an apartment for his poor parents (which he did). He was the embodiment of what has come to be called the China dream, which seemed similar to the American dream.

What a time that was, the summer of 2001. So long ago. These days, I figure it's probably not wise for a Huawei executive to speak with an American reporter. I never heard back from him.

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Photo-Illustration by Justin Metz for Newsweek
The Wrong Trade War